Listen to this article
Richard Bernstein is one of the most influential strategists working in the financial markets. As chief investment strategist for Merrill Lynch, his insights and calls on markets are closely followed. After the gyrations of the past week, he can now answer your questions on the likely outlook.
Mr Bernstein, who has worked on Wall Street for more than 25 years, heads Merrill Lynch’s Investment Strategy Group and its Global Private Client Research Investment Committee. He has been voted on to the Institutional Investor All-America Research team for the past sixteen years.
Mr Bernstein answers your questions below on whether the market moves of the last week represent a small correction or the start of a bigger shift, where commodity prices are heading, how investors should position themselves and how far US earnings growth is likely to slow this year.
More background reading
Do the market moves of last week represent a small correction or the start of a bigger shift?
J. Gritter, Thailand
Richard Bernstein: We have suggested for some time that 2007 would be a year or rising financial market volatility, and I think that is what we are beginning to see. That being said, our expected returns for the S&P 500 (as a benchmark) are about 8 per cent or so, which is not too bad at all.
So, bottom line is that we think equities will provide fair returns, but it might be somewhat more unsettling than during the past few years.
Given increased correlation among asset classes, as evidenced by just about everything dropping last Tuesday, how can investors, and their advisers better diversify?
Doug, Philadelphia, US
Richard Bernstein: You raise an interesting point that most asset classes are very highly correlated. This is a distinct difference from five years ago, when almost every asset class was “uncorrelated” with equities.
Today, only bonds and cash are negatively correlated with the S&P 500, and commodities and gold are roughly “uncorrelated”. Asset classes like hedge funds, non-US stocks, and small cap stocks offer virtually no diversification benefit right now.
Can you explain, in words the average investor can understand, why the precipitous decline in the Chinese market last week caused worldwide mayhem? Simply stated, what does China have to do with my US investments, or my Latin American mutual fund for that matter? Would I be correct in assuming that these days, if China sneezes, the entire world gets the flu?
Ann Wadman, New York
Richard Bernstein: This is an interesting and somewhat complicated question. Suffice it to say that China represents today’s “risk trade” in which global investors were searching to take on more and more risk. Without going into detail, the downfall of the Chinese market was simply a signal to many investors that the “risk trade” might be ending. Thus, any investment that was riskier started to underperform those that were considered more conservative.
Remember that it is actually quite standard stuff for emerging markets to underperform when volatility rises. Our work has been leaning toward the developed markets since late last autumn.
Are we now witnessing the major correction that some bears have been waiting for? Should asset allocations be significantly adjusted away from US dollars and equities for the medium term?
Dr Paul Nailor, London
Richard Bernstein: If one is worried about volatility, then one should indeed diversify away from pure stocks into stocks/bonds/cash. I think this question is particularly interesting because if one is somewhat upset by the recent volatility in the markets, then it indicates that one’s asset allocation is probably inappropriate. Remember the main goal of asset allocation is that the day-to-day, week-to-week, month-to-month gyrations of the financial markets should have no impact on one’s ability to sleep at night.
What is your guess on the markets recovering this week? Are we entering a period of adjustment and if so, have the markets been overvaluing shares? Is the borrowing of the cheap yen to invest in opening markets a factor? Is the US housing market the sign of things to come?
Richard Bernstein: I never think that investors should trade on a short-term time frame like a week.
I think the US housing market is perhaps the most interesting factor to watch, and the factor to give some insight there is initial jobless claims. Housing might have only a hiccup is employment stays reasonably strong. However, if employment weakens, then I think the problems we are now seeing in “subprime” will start to spread. Bottom line: people don’t give back their homes unless they lose their jobs.
How long do you think a cautious small investor, like me, should wait, before entering the equities market again? What signal do I have to monitor?
Andrea Motti, Padova, Italy
Richard Bernstein: As you describe yourself as a “cautious” investor, I think the first thing you need to do is fully review your asset allocation. It sounds from your question as though you jump in and out of the markets, and yet again I’ll say that I think that is often a fruitless exercise. Rather, if your asset allocation is appropriate, you won’t worry all that much about the markets gyrations.
Also, I think a very simple way for investors to be disciplined is to review their asset allocations by date rather than by event. When reviewing by event, emotion tends to take control. We think it is better to review allocations without emotion and by a set schedule. I go into this in great detail in my book “Navigate the Noise - Investing in the New Age of Media and Hype.’ (all my profits from this book go to charity!).
What are the factors that should be considered when attempting to call the bottom of a correction, and how much weight do each of these factors carry with respect to each other?
Philip Valori, Edinburgh, Scotland
Richard Bernstein: This question can be answered differently depending on the time horizon of the investor. As I wrote earlier, I am not a big fan of short-term market timing, and don’t believe that investors should be searching for “the bottom”.
For longer-term investors, I think the most undervalued assets are those that actually benefit from rising volatility, and I think those assets (such as high quality stocks and high quality bonds) should be accumulated without undue concern about the exact timing of the “bottom”.
You say that central banks around the world seem intent on withdrawing liquidity from the global financial markets - and cite this activity as a source of the current downturn in equities. Would you describe the evidence for this, and touch upon why the central banks are doing this?
Kathy Kadane, Washington, DC
Richard Bernstein: One can look at the monetary aggregates or the simple fact that no major central bank is really considering easing right now. My guess is that the financial markets downturn will have less impact on central banks’ policies than most investors currently expect.
What is your view on the future of the carry trade? Is there any reason to believe that it will be completely unwound? What else should we keep an eye if we wanted to pick the bottom of this sell-off?
Jack Browning, New York
Richard Bernstein: Whether is it completely unwound or headline unwound may be immaterial to most investors. As the carry trade is unwound, risky investments are likely to underperform or lose absolute value.
Consider that Merrill’s FX forecast calls for the yen to fall below 110 on the dollar by year end. If our FX team’s forecast is even in the right ballpark, I doubt we’ll be hearing too much about the yen carry trade in a year.
You have written about your concerns regarding liquidity, specifically unregulated money (hedge funds, for example), and how such money may be altering the economic and investment landscape. Can you please share with us your latest thinking on this matter?
Richard Bernstein: One of the reasons that I have felt that the Fed would not rush to ease during 2006 was the incredible amount of credit creation going on outside the traditional banking system. The unique aspect to the financial markets so far this decade has been the combination of liquidity (which many observers discuss) and the leverage used to still create more liquidity (which most observers do not discuss).
If I were a central banker, this credit creation outside the banking system (hedge funds, swaps, LBOs, private equity, CDOs, etc.) would be my main concern. After all, if one were a monetarist, one would say the route to inflation is through credit creation.
Top economists forecast generally favourable economic growth well into the future. Similarly, no end in sight to investable capital is maintaining today’s asset prices. When, if ever, do the various imbalances, mispriced risk, etc. start to affect this rosy outlook?
Mike Croft, Los Angeles
Richard Bernstein: There was an economist named Hyman Minsky who argued that stability breeds instability. Stable markets, he argued, lead people to take on excessive risks, which then cause instability. I think his work characterises the current environment quite well.
Does the new energy market have potential?
Vaios Oreopoulos, Greece
Richard Bernstein: Alternative energy is an interesting area, but people always forget that their profitability and expansion is highly dependent on current oil/gas/gasoline prices. When WTI is at $80/bbl, alternative energies are often quite profitiable. However, at $50/bbl, the list of profitable opportunities gets shorter, and the list gets even shorter at $40/bbl.
Thus, the inherent cyclicality of the energy markets often stymies the development of alternative energies.
I think investors with extremely long time horizons and a substantial appetite for risk might find them interesting.
If the US economy should fall into a recession which metal would likely drop lowest in price or become in short supply?
Ian Leafe, Port Charlotte
Richard Bernstein: If the US economy falls into recession, I think one should probably underweigh commodities in general. I’m not sure that any industrial metal would act defensively. There has been a lot of hype about how commodities might no longer be cyclical. I think we’ve heard that story before (remember the “new economy” and technology?), and should view it warily.
We’ve had the tech boom and wreck, then the commodity boom. What do you think will be the next sector to sizzle?
Tom Row, Australia
Richard Bernstein: I think the word “sizzle” is probably the wrong word to use, from my perspective. I never think that investors should search for the next speculative idea. Rather, I think that investors should search for sectors that have the best fundamentals and invest on that basis.
Right now, with rising volatility, we think that investors should be looking at more conservative sectors such as Consumer Staples (foods, beverages, household products, and the like). The sector is quite undervalued according to our work, and is generally underowned by investors.
You’ve been known to gauge how bullish fund managers and strategists are about stocks, and then take the opposite view. Do you still use this approach, and, if so, where does that put us now?
Aran Lawrence, New York
Richard Bernstein: We do indeed still use this approach. Our model that guages Wall Street’s view of the equity market is called the “Sell Side Indicator”, and is one of our most powerful indicators.
Right now it continues to suggest that investors are bullish (perhaps you’ve heard people talk about “buying on dips”?). It is one of the reasons that we have kept our baseline asset allocation at 50 per cent stocks/30 per cent bonds/20 per cent cash. Our views about rising volatility have led us to this more conservative allocation as well.
Investors such as Warren Buffett and Peter Lynch do not believe that it is possible to time the market and therefore prefer to ‘buy and hold’. What is your view on this?
Tan Siang King, Malaysia
Richard Bernstein: I think that short-term market timing is a relatively fruitless exercise, and that investors should take a longer-term view of investing. However, I do believe that adjusting long-term asset allocations to take advantage of asset mispricings is achievable.
I am interested in the markets ability to maintain an appetite for risk when volatility rises and liquidity is put under pressure. We know banks, hedge funds etc have a tremendous amount of leverage positions, especially in the carry trades. Is a LTCM event lurking and if so, who bears the greatest risk?
Mark Brown, Wellington, New Zealand
Richard Bernstein: It’s somewhat funny that investors always think of risk as a single, specific event. However, risk rarely manifests itself as such a single event. Even in 1998 with LTCM, there were a series of events that gave investors clues that risk aversion might grow.
We prefer to think of risk as popcorn popping in a microwave. Each “pop” seems like an isolated event, but then the bag is suddenly full of popcorn. The same is true in the financial markets. Think about how people have described some of the hedge fund issues, the emerging market issues, sub-prime issues, commodity issues all as single isolated events. Yet, risk aversion is now rather obviously starting to grow. It’s important to remember that when the popcorn bag is completely full (ie, LTCM) it is generally too late to react.
Do you believe that market corrections are a result of expectation of slowing of earnings growth or are they mainly profit taking by investors? Should investors be positioning themselves for shockwaves in other markets if the slowdown continues in the US?
Conrad Lee, London, UK
Richard Bernstein: Remember that there are two main factors that effect equity prices: earnings and interest rates. On the earnings side, there is no doubt that earnings growth is slowing. Our work has been suggesting this for the past quarter or so.
However, slowing earnings growth in and of itself is not a precursor of a correction. There have been many bull markets with slowing earnings growth. The problem is now that central banks around the world seem intent on withdrawing liquidity from the global financial markets. The combination of slowing earnings growth and draining liquidity has historically not been a particularly good one for equities.
What are your views on emerging market debt and high yield bonds? Is it a good time to start investing with specialised managers in these types of asset classes?
Areej Alkulaib, Kuwait
Richard Bernstein: We do not think that emerging market debt and lower quality debt in general is attractive right now.
As an investor, one should always search for scarcities. Right now there is an abundance of low quality debt and an actual scarcity of higher quality debt. That suggests to us that higher quality debt is more attractive. In addition, quality spreads tend to widen as financial market volatility increases.
Considering the high charges of certain ETFs, would you recommend an ETF or a combination of a mutual fund of Asian stocks and another fund of emerging markets debt. Indian stocks are roaring now, but what do you think of Japan?
Maya, St. Louis, MO
Richard Bernstein: There is a very broad range of ETFs from which to choose with a broad range of fees, etc. For some investors, ETFs have tax advantages as well. Regarding mutual funds, managers with good long-term, stable track records are worth investigating.
The actual allocation of ETFs and funds is ultimately, however, an individual decision based on those issues I’ve mentioned and others. In addition, there are times when indexing is preferable to active management and vice versa.
This very much depends on the secular contours of profitability. Without going into too much detail, active managers tend to perform better when profits growth and market leadership are both broad.
For 2007, Mr Bernstein forecasts rising volatility.
“We are surprised that everyone is surprised by the increase in volatility. Historical relationships between monetary policy and financial market volatility have shown relatively clearly that 2007 could be a year of rising volatility,” he says.
Mr Bernstein also says investor should keep a close watch on the US currency.
“While it is not unprecedented for the US dollar to fall during a spike in volatility, investors need to watch this closely. Could the US be losing its status as a safe haven? A weak dollar in a time of slowing growth might complicate the Fed’s tasks quite a bit. We have suggested that attempting to solve the US’s economic problems via the currency rather than through responsible fiscal and monetary policy could be a dangerous route. Perhaps that is coming to the forefront,” he says.